Two Microcap Fund Gems

For years, Wasatch, a terrific little fund family, barely wanted your money. Nine of its 12 funds, including all the funds that specialize in stocks of small companies, were closed to new investors.

Today, only one Wasatch fund remains closed. The most enticing of the reopened funds are Wasatch Microcap Value (symbol WAMVX) and Wasatch International Opportunities (WAIOX). But both will be closing soon.

I think these two funds are worth a hard look despite their super-high expense ratios. Each charges an eye-popping 2.25% annually. Why consider them? Because they are two of the most attractive microcap funds available. And good microcap funds are difficult to find.

Wasatch is on a wretched losing streak. All its funds are in the red over the 12 months ending May 23 -- and most have suffered double-digit losses. So far this year, all but one of the firm's small-cap funds trails the Russell 2000 index of small-company stocks.

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But Wasatch has produced good long-term results since Sam Stewart and Jeff Cardon launched Wasatch Core Growth (WGROX) and Wasatch Small Cap Growth (WAAEX) at the end of 1986. Over the past 20 years, the two funds have returned an identical 14% annualized, putting them in the top 10% of small-company growth funds and beating the Russell 2000 by an average of four percentage points per year. Over the past ten years, the funds have each returned an annualized 10%, landing them in the top 10% among their competitors and an average of five percentage points per year ahead of the Russell.

Until recently, Stewart, Wasatch's founder and chief investment officer, handled the growth of the Salt Lake City firm with aplomb. Today, the firm runs $6.5 billion, still a fairly manageable amount even for a firm that specializes in stocks of small companies (consider that three small-cap funds -- Vanguard Explorer, Baron Growth and T. Rowe Price New Horizons -- each contain more money than all of Wasatch).

Most Wasatch funds hunt for growing companies, but none will buy stocks at sky-high price-earnings ratios. The firm employs some 30 analysts and portfolio managers. Under Stewart's system, every manager is also an analyst, which encourages managers to share ideas and collaborate. "The idea is that the collective wisdom is better than any one person's," says Brian Bythrow, manager of Heritage Value and co-manager of Microcap Value. The big disadvantage: You'll find many stocks in several Wasatch funds -- making it harder to buy and sell stocks without disturbing their prices.

As the firm has grown, it has branched out. In 2004, Wasatch launched its first midcap fund, Heritage Growth. Less than a year ago, it launched Heritage Value, a large-company fund, and Emerging Markets Small Cap.

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Why the growth spurt? "We had eight or nine funds, and all of them were closed," recalls Bythrow. "We had run out of capacity in U.S. small caps, and we want to grow this firm."

Unfortunately, the growth in the number of funds has coincided with a deterioration of performance. The unanswerable question: How much of the weak results is related to the company's growth?

What's clear is that the tepid performance has come during a period when Wasatch's favorite kinds of stocks have soured. Its funds have always piled into consumer stocks, health care and financials -- areas of the market that have hit rough patches lately. What's more, it's likely that consumer stocks and financials will continue to suffer for some time.

Small-company stocks, in general, aren't very attractive just now. Their price-earnings ratios are still a bit higher, on average, than the P/Es of large-company stocks. Given the inherently greater risks of small companies, that makes no sense. Moreover, large companies garner a far greater percentage of their revenues from exports -- and exports are a crucial source of profits in a period when both the dollar and the U.S. consumer are weak.

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Bottom line: I don't see a compelling reason to invest in most of Wasatch's reopened funds. Time will tell whether these funds have merely hit a speed bump, as I suspect, or Wasatch's managers have really lost their touch.

I am more sanguine, however, about Microcap Value and International Opportunities, tiny funds that are likely to be open only a month or two longer. Currently, Microcap Value has $120 million in assets and International Opportunities has $55 million. Once the funds take in roughly $50 million apiece, Wasatch plans to slam their doors shut again -- not only to new investors but to existing ones, as well. That was the situation for years, before the funds' recent reopenings.

International Opportunities is especially attractive because few analysts track small, foreign companies and because foreign stocks have a tailwind behind them.

Results have been solid. Microcap Value has returned an annualized 14% over the past three years, putting it in the top 5% among small-company growth funds through May 23. Nearly five years old, the fund excelled in its first two years, as well. International Opportunities has returned an annualized 20% since its inception three years ago.

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Because of Wasatch's collaborative approach, the records of individual managers matter less than at many shops. Bythrow, lead manager of Microcap Value, has been an investment professional for a dozen years. Blake Walker, day-to-day manager at International Opportunities, has been at Wasatch since 2002.

Nowadays, you don't want too much of your money in stocks of small companies -- foreign or domestic -- but you should always keep some money, say 5% or 10%, in them. After all, the market has a habit of surprising us.

What about those 2.25% expense ratios? Normally, they'd make no sense, but the fund firm's record makes them justifiable.

Microcaps -- the smallest of small companies -- tend to do better over the long term than merely small companies. That won't likely occur during a period of large-cap dominance. But getting a small taste of both these funds makes sense to me -- before they shut again.